IRS taxes usually apply if your debt is discharged, but there are exceptions

Most people know that if they receive cash, it will probably be taxed unless it is an honest gift. Most people know that if they receive an estate, that estate is likely to be taxed again, unless it is an actual gift. More on giveaways below. But what if you don’t seem to have anything? Say, your uncle lends you money and then tells me not to worry about paying it back? Can this be taxed somehow?

With the IRS, COD is short for “cancellation of debt.” Like it or not, when your debt is canceled or discharged, in many cases the tax code treats the discharged debt as cash income that you must report. If you owe a bank $500,000, but the bank forgives you, it’s like the bank just loaned you $500,000, so the IRS and the state want a cut.

There are other types of phantom income that can be taxed even though you don’t have the cash. However, COD income tops my list of lesser understood tax pitfalls. The good news is that there are exemptions and tax exemptions that may prevent you from writing a check to the IRS. So you are not caught out, here are some useful rules about COD earnings.

Loans that are forgiven as gifts are not taxed. If your debt is canceled by a private lender – say a relative or friend – and the cancellation is intended as a gift, you have no income. Although it is not income to you, if the lender forgives more than $17,000 per year (the annual gift tax exclusion), it may count against his lifetime exemption from gift tax. This may make it best to forgive these loans all at once.

There are exceptions to your home mortgage. During the 2007 financial crisis, Congress reduced the IRS’s ability to file tax returns. Applying only to your primary residence, the Mortgage Debt Relief Act excluded as income up to $2 million in debt relief (an amount that drops to $750,000 from 2021 to 2025). The Mortgage Debt Relief Act also included loans and subsequent debt forgiveness for funds borrowed to make substantial improvements to the primary residence.

The act originally covered 2007 to 2010 and was eventually extended to 2020. Then, the Consolidated Appropriations Act extended the exclusion from 2021 to 2025. However, the maximum amount of excluded debt is now limited to $750,000. Not surprisingly, if your lender writes off your portion of the mortgage, you’ll have to reduce your home equity by the amount of debt that doesn’t count as income for you.

Note that this special benefit for forgiven mortgages is not automatic; To take advantage of this, you must file IRS Form 982, with the intimidating title, “Reduction of Tax Credits Due to Repayment of Debt (and Section 1082 Basis Adjustment).”

Bankruptcy discharge is not taxable. If your debt is discharged while you are bankrupt as part of a court-approved bankruptcy plan, it is not taxable as income. However, the amount of debt discharged goes toward reducing certain tax attributes, such as net operating losses or the basis of the property. Again, the rules are complicated and require filing IRS Form 982.

If you are insolvent, you get a pass. Even if you’re not bankrupt, if you’re “insolvent” when you pay off your debt, there’s no charge. Insolvency is a simple test that means your liabilities exceed your assets. To escape taxes, your liabilities must exceed your assets more than the amount of debt paid. Say you have $1,000 in assets and $2,000 in liabilities, so you’re $1,000 underwater. If your bank forgives $500 of debt, that’s not income because the amount forgiven is less than the amount you owe.

Disputed debts are different. Some taxpayers argue that the debt was void in the first place, so no debt income can occur. It can be a smooth position where it works, or a claim that all or part of the debt was bad. The IRS tends to read this exception narrowly, but there are some decided court cases that can help if you’re concerned.

The argument rests on the notion that a discharged debt is not income if the taxpayer objects in good faith to the original amount of the alleged debt. In Presslar v. Commissioner, 2167 F.3d 1323 (10th Cir. 1999), the court held that a subsequent settlement of a disputed debt is treated as the amount of the debt for tax purposes. In other words, the excess of the original debt over the amount determined to be paid may not be taken into account in the calculation of the gross income.

Thus, writing down $1 million in debt to $400,000 typically results in $600,000 in income. But if there was a debt, and the borrower and lender agreed that only $400,000 was due, that might be different. Be careful though. The IRS focuses on arguments that the debt occurred when it appears that there really was no dispute, that only when the taxpayer mentioned the dispute is tax time.

Price adjustments are also not revenue. There is no income if an individual buys the property and the seller later reduces the price of the property. The buyer’s basis in the property, however, is reduced by the amount of the adjustment. These days, this exception can be especially important. Say you bought a rental unit five years ago from a bank for $500,000 and you still owe the bank $400,000. The unit is now only worth $350,000. The bank agrees to reduce the debt by $50,000. If it’s just debt relief, it’s COD income. But if it’s written as a purchase price adjustment, it’s not.

Some forgiven student loans are not income. Another exception protects certain student loan forgiveness. In the past, the IRS’s rules for taxing student debt depended on the nature of the benefit and who received it. Thus, traditionally, students who had their debts forgiven because they worked for a period of time at public institutions were generally home free. Recently, federal tax rules have become more liberal.

Until 2021, student debt cancellation was generally considered a form of income and therefore taxable at both the federal and regular state levels. But in March 2021, America’s bailout changed that. By the end of 2025, the US Govt No Consider discharged student loan debt as taxable income. Therefore, President Biden’s full reduction in student debt is not subject to federal income tax.

However, in some states, including California in particular, borrowers may have to pay State Income tax on all those canceled loans. California has a bill to replace it, but it doesn’t appear to have passed yet.

The exception is the deductible percentage. There is no income from the cancellation of the deductible debt. This means that if the lender were to write off the home mortgage interest (only the interest, not the principal), and that interest could have been claimed as a deduction on your tax return, the borrower would have no taxable income.

Be ready with IRS Form 1099-C. No one likes receiving an IRS Form 1099. Generally, businesses must issue forms to any recipient (other than a corporation) that receives $600 or more during the year. This is only the main barrier, but there are many exceptions. Therefore, you probably receive a Form 1099 for every bank account you have, even if you only earned $10 in interest income. The key is IRS compliance.

Each Form 1099 contains the payer’s employer identification number and the payee’s Social Security number. The IRS matches the forms with the 1099 payer’s tax return. There are many varieties of them and there are also COD for income. The IRS provides a list of creditors that must report Form 1099-C. It includes lenders regularly engaged in the business of lending money, such as banks, credit unions, credit card companies, and any entity whose substantial trade or business is lending money.

If you receive a Form 1099-C and disagree with the amount shown, write the creditor to issue an amended Form 1099-C showing the correct amount of the canceled debt. If you believe that a canceled debt is not income to you because you are insolvent or for some other reason, do not ignore the 1099-C. Instead, you must claim it on your tax return and explain why it is not taxable. And you may need a tax opinion and/or disclosure on your tax return.

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